Slow but significant progress

Aflurry of announcements in recent weeks means big changes for China's economy. The Qualified Domestic Institutional Investor (QDII) scheme received a boost as banks, insurance companies, fund managers and stock brokers were permitted to start using foreign currency reserves to invest in overseas financial assets. Meanwhile, on the home front, share listings resumed after a year of inactivity as listings of secondary stock, convertible bonds and other securities were given the green light. Yet concerns about China's economy still lurk in the background. Interest rates have been raised in a bid to bring investment-led growth under control as banks met half the government's full-year loan target in the space of three months. Questions have been asked as to how well these banks can cope if economic fortunes show signs of slowing. Speaking to CHINA ECONOMIC REVIEW, Jing Ulrich, managing director and chairman of China equities at JP Morgan, pieced together the puzzle.

Q: What is the likely impact of the recent reform of the QDII scheme?

A: It is in keeping with China's long-term goal of liberalizing its capital account and, in the near term, it will help alleviate some of the upward pressure on the renminbi. The move will be beneficial for Chinese insurance companies, the National Social Security Fund and fund management firms who are eager to diversify away from purely renminbi-denominated assets. For a long-term strategic investment, they want to diversify into other asset classes and other currencies. Initially, Hong Kong will be the market of choice as it's the most logical place to go. I expect the money will be invested in Chinese companies listed in Hong Kong, as well as in some fixed-income securities in Hong Kong and the US. The amount is likely to be modest to begin with but should escalate gradually.

Q: To what extent can these changes, announced shortly before President Hu Jintao's visit to Washington, appease US concerns about China's currency?

A: Initially the impact on the yuan will be minimal because outflows this year will probably amount to some US$4-5 billion at most, which is considerably less than inflows. Last year China's current account surplus reached a record 7% of GDP and its capital account was also in surplus. FDI inflows exceeded US$60 billion, so outflows of US$4-5 billion are comparatively small. However, I think there might be a psychological impact. China is making a gesture to the US and other trading partners that it is taking steps to liberalize the capital account.

Q: Isn't there a risk that allowing Chinese institutions to buy foreign financial assets will lead to more US T-Bond purchases?

A: I don't anticipate any reduction in China's US Treasury Bond holdings as each month – without QDII – China's purchase of US Treasuries is increasing as a result of the massive build up of foreign exchange reserves. Under QDII, banks and insurance companies are unlikely to invest their entire quota in US Treasuries – they can invest in other currencies and in commodity-related asset classes such as gold. If China's purchase of US Treasuries continues at the pace we've seen in the last two years, it would clearly help to keep US interest rates low, which in turn stimulates US consumption. But the size of QDII flows is so small that I don't believe there will be a meaningful incremental impact on US interest rates. In the next three to five years, the pace of outflows will probably accelerate, but we should also bear in mind that some domestic institutions will be reluctant to invest overseas because they don't want to incur foreign exchange losses. Everyone is expecting the renminbi to appreciate against other currencies, particularly the US dollar, so if they were to make a large investment in US dollar-denominated assets now, they would incur losses later.

Q: The authorities have also allowed domestic share listings to resume. In addition to share reform, what needs to be done to make the markets more competitive?

A: The non-tradable share reform is removing a long-standing overhang on the A-share market and, as a result, the market has performed reasonably well over the past six months. But to fundamentally improve the performance of the equity market in China, the authorities must change several things. One is to improve corporate governance through better transparency and quality of management. It is also important to align the interests of company management teams with those of shareholders by introducing incentives to management so that their compensation is linked to company performance and the performance of the company's share price. A more sustainable way of boosting the market is to introduce better quality companies. China needs to have a more diversified pool of companies for investors to choose from – not only state-owned enterprises (SOEs) but also private companies and, possibly, subsidiaries of foreign companies conducting business in China.

Q: Is sufficient progress being made in developing China's bond market?

A: Up until recently, the capital market – including bonds and equities – played a minimal role in meeting the financial needs of the economy: 99% of these needs were met by bank loans last year while the capital market accounted for just 1%. It's encouraging that the authorities are now trying to develop the equity and bond markets to provide other avenues for corporate fund-raising. But they need to allow more companies to issue bonds. Right now there are a very limited number of corporate bonds, so there isn't enough competition for the banks. As equity and bond markets develop more rapidly, banks can reduce their role in financing the overall economy. It is a win-win situation if the capital market is allowed to develop in a more robust way.

Q: Several reports have expressed concern about the amount of non-performing loans (NPLs) still in the banking system. By transferring NPLs from the banks to the asset management corporations (AMCs), haven't bad loans simply been moved from one SOE to another? Will it all end in a huge government bailout?

A: The AMCs were created in 1999 and in the last seven years they have taken over US$325 billion in NPLs, resolving over 30% of those, so there are still a lot of NPLs left. Three of the Big Four state banks have already received capital injections and have transferred a large amount of their NPLs to the AMCs. Once bad assets are transferred to the AMCs, one could assume that this is already a form of bailout. Alternatively, you may want to think of it as national debt – the government will have to deal with it through fiscal means. The good thing is that the stock of bad loans from the past has been largely transferred away from the banks. Three of the Big Four state banks have robust balance sheets now and are making good profits. As long as we don't see the creation of new bad loans, the NPL problem can be dealt with because China has the resources to cope with the historical stock of bad loans.

Q: Given that fixed-asset investment and loan growth remain high, isn't there a growing risk that the economy will take a hit and new NPLs will be formed?

A: Fixed-asset investment growth in the first quarter of this year was 27%, well above the official full-year target of 18%. The government is trying to reposition growth away from fixed-asset investment towards domestic consumption but that is a difficult goal to achieve. I don't foresee fixed-asset investment growth slowing dramatically in the future. We've seen the central government taking action to slow investment-led growth – interest rates have been raised, with one-year benchmark lending rates going up to 5.85%, while deposit rates were kept steady. The National Development and Reform Commission also introduced measures to control overinvestment in some of the so-called "overheated" industries. I expect further measures will be announced later in the year.

Q: How do the banks respond to struggling SOEs that ask for loans, when giving such loans wouldn't make commercial sense?

A: This kind of tension between the commercial objectives of the banks and an old style SOE mentality is to be expected. By the end of this year, three of the Big Four state banks will have become listed entities and they account for over 50% of financial sector assets. As listed entities, these banks will have to be accountable for the lending decisions they make. I really hope they won't succumb to pressure from SOEs looking for loans to keep them afloat. China's banks need to become more commercially oriented and this process will involve some pain: there will be bankruptcies and state-owned enterprises may have to lay off workers. However, I believe some workers can be absorbed by the private sector economy. Since SOE reform began 10 years ago, an estimated 30 million people have lost their jobs, but the unemployment rate hasn't surged to unmanageable levels. That is because, in large part, excess workers have been absorbed by the private sector.

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